The paper "Incident Command System " is a perfect example of a business literature review. Capital structure is the mix of equity, debt and firms retained earning. The theories tend to play an important role in identifying which source is cheap and how can the three be mixed to maximize the benefit at the same time minimizing the cost. And it is evident that small business enterprise prefers using debt financing. The test was carried on the outside financing and it was realized that Small business enterprises received a lot of attention than large financing in the determination of creditworthiness of the business to repay the debt back “ Freedman, j.
and Godwin, 1994, incorporating the micro-business” The growth of the firm is also considered in understanding the capital structure and how expensive it will be to use a certain mix at a particular stage of the business. In addition, the efficiency of the financial system also dictates what choice the firm will prefer using” Booth, L., Aivazian, V., & Demirgue-kunt, A. (2001). Capital structure in developing countries. ” CAPITAL STRUCTURE THEORIES Cassar and Holmes (2003) It describes three theories of capital structure.
They include; a. Pecking order theory- It advocated that funding capital structure depends on a certain criterion that is, the firm has to use its internal finances before looking for debt and lastly using firms equity as the option of the last resort. The weakness of this theory is that some small-medium businesses don’ t insist on this order but it uses equity directly without considering using borrowing debt from financial institutions such as banks. Static trade-off theory – It is the benefit arising from the tax shield due to use of debt to finance capital structure in comparison to the cost of using such debt that is; bankruptcy cost and agency cost. Bankruptcy cost arises when the firm becomes unable to pay off its debt or insolvent and it is supposed to be liquidated in order to pay off the debt.
The cost incurred in the process is called bankruptcy cost. Agency cost is the cost incurred in monitoring the use of such debt and it is always instituted in order to protect the interest of debt-holders and business owner.
Therefore when the monitoring cost is high the relationship or possibilities of default of such debt is high. A tax shield is the tax benefit the business get due to the use of debit and is always calculated by multiplication of the tax with the debt. Static trade-off theory is arrived by: Benefit= TD – FD. Where; T is a tax imposed to the business. D is the amount of debt used. F is the proportion of bankruptcy cost or agency cost incurred when a certain level of debt is used. The theory proposes that the firm can increase the amount of debt used as the benefit increases to a point where it stagnates, further increase beyond this point will lead to a decrease of the benefit of using debt to even a negative value. Information asymmetry theory- This proposes that there is a difference in the information between the potential debt-holder and the business that is, the firm has enough knowledge on the future of the firm and it might consider using its internal equity for example retained profit to avoid the risk of using debt and also the debt-holder might have high expectation thus fixing high-interest rate which will make the use of debt more costly than firms equity.
This theory opposes the pecking order theory in some ways since pecking state that the firm will consider using debt then equity will be the last option.
Cassar, G. & Holmes, S. (2003) ‘Capital structure and financing of SMEs: Australian evidence’ Accounting and Finance, 43, pp. 123-147
La Rocca, M., La Rocca, T. & Cariola, A. (2011) ‘Capital structure decisions during a firm’s life cycle’ Small Business Economics, 37, pp. 107-130
Qui, M. & La, B. (2010) ‘Firm characteristics as determinants of capital structures in Australia’, International Journal of the Economics of Business, 17(3), pp. 277-287
Freedman, j. and Godwin, 1994, incorporating the micro-business, in A. Hughes and D.J. Storey eds, Finance and the small firm (Routledge, London) 232-283
Booth, L.,Aivazian, V., & Demirgue-kunt, A. (2001). Capital structure in developing countries. Journal of money credit and banking, 36(2), 956-970.